UPDATE 2-Co-op Group's influence in bank weakens in new fundraising

* Richard Pym to step down as bank chair by end of year (Adds reaction, further details, IPO options)

By Matt Scuffham

LONDON, May 9 (Reuters) - Britain’s Co-operative Group will lose more control over the Co-op Bank after the lender’s latest fundraising, raising questions about whether the bank can retain customers attracted by the group’s ethical image.

Bondholders including U.S. hedge funds took control of the loss-making bank last year as part of a recapitalisation to fix a 1.5 billion pound ($2.5 billion) funding gap which saw the Co-op Group’s stake fall to 30 percent.

After an initial loss of custom, however, the bank said in March its core retail deposit balances fell by less than 1 percent last year.

The bank, Britain’s eighth-biggest with 1.6 million current account customers, on Friday confirmed it would raise 400 million pounds by selling new shares, having said in March it needed the funds to cover the cost of past misconduct.

The Co-operative Group, which is grappling with its own problems after a report this week by former government minister Paul Myners savaged its corporate governance practices and questioned its future, said its stake would fall further as a result of the fundraising. But it added it would remain the bank’s biggest single shareholder. Two sources familiar with the matter told Reuters the group’s stake would fall to 20 percent.

“In the court of public opinion the Co-op Bank brand becomes less and less credible as the amount of Co-op Group ownership falls,” said John Thanassoulis, professor of financial economics at the University of Warwick.

“The question will come when the bank does something that appears to the bank and the group not to be in tune with the ethical values of the Co-operative Group,” he added.

Business minister Vince Cable has the power to strip the bank of the right to use the brand if it becomes misleading to the public. But a spokeswoman at the business department said that would only be applied in extreme circumstances.

“This is obviously a high hurdle. The Secretary of State (Cable) would need to be satisfied there was genuine evidence suggesting likely harm to the public, whether to individuals or businesses,” she said.

Co-op Bank’s Chief Executive Niall Booker has vowed to keep “values and ethics” at the heart of the business. The bank, whose ethical stances include not lending to the likes of weapons makers, said the decline in the group’s stake would have no bearing on whether it can still use the Co-operative name.

“The Co-op Bank owns the rights to its name. There’s no reason to think there’s an issue with the name,” he said.

Co-op Bank needed to raise the new funds because its core tier 1 capital ratio, a measure of a bank’s financial strength, had dropped to 7.2 percent, dangerously close to the 7 percent minimum required by Britain’s financial regulator.

The bank said its four other biggest shareholders had committed to take up 31 percent of the new shares. Two of those - hedge funds Silver Point and Perry Capital - have been granted the right to nominate a director to the board of the bank for as long as they hold a stake of at least 5 percent.

Chairman Richard Pym will step down from his role by the end of the year, the bank said. The 64-year-old, who is also chairman of the body set up by the government to manage the state’s toxic banking assets, was appointed last June to steer Co-op Bank through its restructuring.

Co-op Bank said it was still considering a stock market listing on the London Stock Exchange which was its long-term intention after the previous capital increase.

The bank’s bondholders are assessing ways of exiting their investment and, as a condition of the capital raising, the board is establishing an initial public offering (IPO) committee to assess the feasibility of a stock market listing and make recommendations to the board on the timing of such a move. The committee will consider the bank’s options every three months.

Co-op Bank said the timing of any IPO remained uncertain because of several factors including regulatory investigations.

The Prudential Regulation Authority and Financial Conduct Authority have launched an investigation into decisions and events at the bank before the full extent of its financial problems emerged in June last year.

If the bank decided to proceed with an IPO, it would join several rivals preparing for London listings including TSB, Santander UK, Virgin Money, Aldermore, OneSavings and Shawbrook.

Bankers have not ruled out a possible outright sale of the bank, perhaps to a private equity buyer, but consider it unlikely given the challenges the business is facing.

The bank reported a loss of 1.3 billion pounds last year and said it wouldn’t make a profit in 2014 or 2015.